Suitability and Fiduciary Duty

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In a blog posting for The Wall Street Journal on February 11, 2010, Mike Miliard quoted the president of a financial and estate planning firm who said:

“I think it’s so funny when advisers ask their clients to do a risk tolerance test. I never do a risk tolerance test because I know the answer: everybody has a high risk tolerance when the market’s going up, and they have zero risk tolerance when the market’s going down.”

Although most advisors undoubtedly have clients who meet that description, RIAs must still make certain that their investment recommendations are suitable.

On February 17, 2011, the SEC imposed remedial sanctions against an IAR in Aliso Viejo, California. The SEC’s complaint alleged that the IAR employed a number of high-risk investment strategies without disclosing to clients how risky they were. The complaint further alleged that the IAR engaged in those strategies, even though he was aware they were unsuitable for clients with minimal tolerance for risk. The SEC’s complaint charged that the IAR knew these strategies were too risky in view of clients’ age, retirement status, and need for funds in the near future.

According to the SEC’s complaint, the IAR misrepresented that the investments were guaranteed. He also told clients that there was practically no risk involved with his investment strategy.

Documenting the Suitability of Investment Recommendations

Many IARs started their careers in the financial services field as registered representatives for broker-dealers. As brokers, they owed a duty only to recommend suitable investments for clients. As part of their suitability analysis, brokers must consider the client’s risk tolerance, income, net worth, investment objectives, and financial needs. However, an RIA’s fiduciary obligation goes far beyond determining whether investments are suitable for a client.

Even though it should be second nature for IARs to act as a fiduciary, it is still extremely important for them to document that they made a suitability determination for each and every client. Although the Investment Advisers Act does not explicitly impose a suitability requirement, RIAs should be able to prove to examiners that the firm’s advice is suitable in view of the client’s financial situation, risk temperament, and investment objectives.

RIAs must create and retain books showing that all investment recommendations were suitable. This is accomplished through documentation such as:

An IPS is a document drafted by an investment advisor based on input from the client, which defines the client’s investment goals, objectives, risk tolerance, and liquidity needs. The IPS describes the strategy used by the advisor in an effort to meet those investment objectives within the client’s established parameters.

Intentionally or unintentionally, RIAs sometimes change their investment style in an effort to improve their performance. Style drift, as it is sometimes called, occurs when a portfolio manager shifts away from the firm’s stated investment style or objective and may subject clients to risks not consistent with their risk profiles. The result is that clients’ portfolios may contain unsuitable investments.

Whether an RIA is SEC or state registered, examiners will expect to see documentation that the firm has met its duty to recommend only suitable investments. Furthermore, an RIA’s compliance/supervision manual should contain policies and procedures for determining and documenting suitability. As an example, the South Carolina Securities Division’s Examination Program Overview reiterates that examiners will review records relating to suitability. South Carolina’s Examination Program Overview also requires RIAs to maintain written information about each advisory client, which is used as the basis for making recommendations and giving investment advice to that individual. All documentation must be retained for the period set forth in the Books and Records Rule.

Disclosure is No Substitute for Suitability

RIAs must retain adequate information about their customers documenting the suitability of recommendations made.. Disclosing that investments are risky does not negate an advisor’s duty to recommend suitable investments. Even if an advisor has books and records to show that clients were warned about the risks of investments, the firm exposes itself to possible litigation and regulatory sanctions if a client’s portfolio is filled with inappropriate investments.

If an investor complains to the SEC or the state about the suitability of investments recommended, a regulator may look first at the firm’s disclosure brochure. The regulatory investigation is likely to go badly if the RIA’s brochure does not provide a detailed description of any significant or unusual risks arising from the firm’s methods of analysis and investment strategies. If the RIA recommends a particular type of security, the brochure should explain the material risks involved. As we saw in The New and Improved Form ADV, the new Form ADV requires that RIAs disclose these risks in plain English.

The Big Picture

In discussing the concept of suitability, commentators always seem to cite the example of an elderly widow who finds herself invested in penny stocks or some other risky investment. As a practical matter, suitability is not always so clear-cut. Problems sometimes occur because an IAR is not aware that a client’s financial situation has changed or neglects to document a client’s risk profile.

Although many advisory contracts state that it is clients’ responsibility to notify the firm of changes in their financial situation and investment objectives, RIAs should take steps to ensure that client information is current. Some RIAs put standard language at the bottom of every email warning clients that they should notify the firm promptly if their financial situation changes.

IARs should document that they asked for updated information during meetings with clients to confirm their original suitability analysis. Policies and procedures should require IARs to conduct a suitability analysis at the onset of the relationship and to update that document at least once per year. If a client wants to pursue an aggressive investment strategy that is clearly unsuitable, the IAR should draft a document for the individual to sign that acknowledges the potential losses that may occur. Even with a signed acknowledgment, however, it may be prudent for an IAR to withdraw from managing the client’s funds. There is a possibility that a client may be suffering from diminished capacity.

On a regular basis, RIAs should be rereading Item 8 of their Form ADV Part 2 disclosure brochures, which requires advisory firms to thoroughly explain the material risks associated with each significant investment strategy or method of analysis used. This process will help RIAs ensure that their investment strategies are suitable.

Supervisory review is a safeguard ensuring that the firm is not recommending unsuitable investments. To make supervisory review easier, one solution is for an RIA to maintain trade blotters with information next to the transactions, such as the client’s age, investment objective, and net worth. A trade blotter is a record of trades made over a period of time, and includes important information like the price, time, and order size. Typically, the blotter is created by trading software, which documents the trades through a data feed.

Recommending suitable investments is more than just a regulatory obligation. According to attorney Thomas D. Giachetti in the August 2011 issue of Investment Advisor, far too many investors bring cases claiming lack of suitability. Therefore, RIAs must continuously put the onus on clients to notify the advisor if there are changes in their financial situation.

Les Abromovitz

Les Abromovitz is the author of The Investment Advisor’s Compliance Guide, published by The National Underwriter Company/ALM Media.

An attorney and member of the Pennsylvania bar, Les has handled hundreds of consulting and publishing projects for National Compliance Services, www.ncsonline.com, a leading compliance and regulatory services firm. He has conducted a number of seminars and training sessions dealing with compliance subjects. Les is also the author of several white papers that analyze compliance issues impacting Registered Investment Advisors (RIAs)‎.